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Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)

Guest blog: NGDP Targeting is NOT just for Central Banks!

By David Eagle

Because of Lars Christensen’s blog on “Market Monetarism vs Krugmanism,” I am interjecting a new topic into my guest blog series. I agree with the comments from JJA and Scott B. on Scott Sumner’s blog. While some of the market monetarists do not believe in the effectiveness of fiscal policy, I think there is a great opportunity for those fiscal conservatives among us to openly welcome Keynesians to bring fiscal policy into the realm of NGDP targeting. I agree with JJA that NGDP targeting should be the aim for BOTH monetary and fiscal policy. In other words, both monetary and fiscal policy should target NGDP, although under normal times that responsibility should fall on the central bank. Let me restate this very important statement: The role of fiscal policy in stimulating aggregate demand should also be governed by the NGDP target. In other words, if NGDP is below target and the central bank says it needs help from fiscal policy to boost NGDP, then those in favor of using fiscal policy should advocate for fiscal stimuli. However, when NGDP is at or above target, then the fiscal policy should be directed towards fiscal surpluses to make up for the previous deficit spending. If the central bank and fiscal authorities were to agree on a NGDP target, then we would not have had the huge fiscal deficits that we did have preceding 2008.

However, unfortunately the central bank and fiscal authorities have not been following a mutually agreed upon and transparent NGDP target. Because of the murky waters concerning what the central bank is doing, fiscal and monetary policy often work in different directions. In particular, when the central bank targets inflation, it often is not clear what the central bank’s intentions are with regard to NGDP. (Because I agree with Scott Sumner that we should treat NGDP and aggregate demand as the same concept, even a central bank targeting inflation should be transparent about what its intentions are concerning aggregate demand, i.e., NGDP; but alas central banks today are not that transparent.) Because of these murky waters, politicians have often been able to pass politically desirable tax cuts and increased government spending under the guise of stimulating the economy (i.e., stimulating aggregate demand, i.e., stimulating NGDP), even though the central bank is content to let bygones be bygones and keep NGDP on its current track, but consistent with its future inflation target.

The Japanese Experience:

Take Japan, for example, where the Bank of Japan was under pressure to be more independent of the Japanese Government and be more like “western central banks” at maintaining price stability.[1] Then came the 1990s and the Japanese Government followed Keynesian fiscal policy to stimulate the economy. Meanwhile the Central Bank of Japan was determined to follow in Paul Volker’s footsteps of regaining credibility for maintaining price stability. As Scott Sumner (2011) reported, the Bank of Japan actually pursued restrictive monetary policy at times when the Japanese government was trying to be expansionary with its fiscal policy.[2] Because they were pulling the economy in two different directions, the result was (i) the Bank of Japan offsetting much of what the aggregate-demand effects of the fiscal stimuli, and (ii) the national debt in Japan skyrocketed from 51% of GDP at the beginning of the 1980s to over 220% now. Then came 3/11/11, the day of the triple supply shock in Japan – earthquake, tsunami, and nuclear crisis. In addition to their enormous national debt, now Japan faces the high costs of rebuilding.

Lack of Coordination between US Fiscal Policy and the Federal Reserve:

The United States I think is another example. In 2003, the Bush administration passed tax cuts and kept them in place for a long time (they are still in place today). These tax cuts were to stimulate the economy. However, at the same time, the Federal Reserve was content to “let bygones be bygones” and let the NGDP base drift caused by the 2001 recession continue (see my guest blog that explains NGDP base drift). As a result, if the tax cuts did have any stimulative effect, the Federal Reserve would have countered them with monetary policy. On the other hand, if both the Federal Reserve and the Bush administration had agreed upon a NGDP target, and if that NGDP target was above where NGDP was at the moment, then the Federal Reserve could have tried to boost NGDP by using tools that Ben Bernanke said he had and that Scott Sumner believes he had.[3] Also, as I will explain in a later guest blog, expectations has an important role to play. If the public expects the central bank and fiscal policy to succeed in boosting NGDP up to its target, then they will be more inclined to spend more because of higher expected short-term inflation, helping the monetary and fiscal policy reach this goal. Unfortunately, despite all the rhetoric about the transparency of inflation targeting (IT), IT is not as transparent as NGDP targeting. I believe the ultimate in transparency for both monetary and fiscal policy is NGDP targeting.

The Two-Headed British Media:

Sumner (2011) reports an example in Britain of how the lack of transparency with regard to aggregate demand, i.e. NGDP, led to the British media simultaneously condemning both fiscal and monetary policy simultaneously:

“Recent events in Britain provide a perfect example of the confusion generated by drawing this sort of false dichotomy between monetary and fiscal policy. The government of Prime Minister David Cameron has been sharply criticized for its policy of fiscal austerity. The recovery from the recent recession has been even weaker in Britain than in the United States, and there are fears that budget cuts will lead to a double-dip recession. At the same time, the press has been highly critical of the Bank of England for allowing inflation to rise far above the 2% target. But these criticisms cannot both be correct: Either Britain needs more aggregate demand or it does not. If it needs more, then the inflation rate in Britain needs to rise even higher, because the Bank of England needs to provide even more monetary stimulus. If inflation is too high and Britain needs less aggregate demand, then [the British] should desire fiscal austerity that would slow the economy. The press seems to believe in some sort of policy magic whereby fiscal stimulus can create growth without inflation and monetary tightening can reduce inflation without affecting growth.” (brackets added after consultation with Scott Sumner)

If the British media is confused, then obviously the British public is confused. If British fiscal and monetary policy both pursued a NGDP target, I believe the British media and British public would finally understand that it cannot criticize both fiscal and monetary policy under these circumstances. As I said before, expectations plays an important part to boosting aggregate demand (NGDP), and I know no better way to guide the public expectations concerning aggregate demand than a credible and transparent NGDP target for both monetary and fiscal policy.

Summary: NGDP targeting for both fiscal and monetary policy:

In summary, if the central bank and those in favor of fiscal policy could agree on a NGDP target and then jointly pursue that target, our economies would be so much better today. In particular, on the fiscal side, we would have no justification for the high federal government debt we have accumulated. If fiscal policy followed a NGDP target, then over half the time we should have fiscal surpluses rather than fiscal deficits. Also, a NGDP target is so much more transparent for both fiscal policy and monetary policy than the murky waters of inflation targeting that we face today. With fiscal policy and monetary policy following a NGDP target, expensive fiscal stimuli could not be justified to stimulate the economy when NGDP is at or above target.

[1] Ben Bernanke (http://www.federalreserve.gov/newsevents/speech/bernanke20100525a.htm) reported in 2010, “The importance of central bank independence also motivated a 1997 revision to Japanese law that gave the Bank of Japan operational independence.9 This revision significantly diminished the scope for the Ministry of Finance to influence central bank decisions, thus strengthening the Bank of Japan’s autonomy in setting monetary policy.”

[2] Scott Sumner states, “But the Japanese twice tightened monetary policy in an environment of zero inflation (in 2000 and 2006), so it would be hard to claim that they were trying to create inflation.”

[3] Sumner (2011, p. 4) states, ““But the Fed itself never claimed to be ‘out of ammunition,’ even after rates hit zero. Indeed, Chairman Ben Bernanke has repeatedly stressed that the Fed still has many options for boosting demand, and he has proved the point with two rounds of ‘quantitative easing.’ Indeed, it is hard to see how a fiat-money central bank would ever be left unable to boost nominal spending. That would logically imply it was unable to raise the rate of inflation – that is, to ‘debase the currency,’ which it can always do. There is no example in history of any fiat-money central bank that tried to create inflation and failed.”